China takes on hedge fund bosses Ackman, Bass, Tepper in yuan battle

As far as financial market duels go, China versus some of the world's most storied hedge funds is as big as it gets.

Money managers making bearish bets against the yuan, including top investors Kyle Bass, David Tepper and Bill Ackman, are pitted against Chinese policymakers who are trying to manage a more orderly decline of the currency, the Wall Street Journal (WSJ) reported at the weekend.

According to the WSJ report, some of the traders are penciling in a decline in the yuan of as much as 40 percent.The currency has already fallen about 5.6 percent against the dollar since August, when a sharp devaluation by the People's Bank of China (PBOC) roiled markets, to trade at 6.5790 on Monday.

Which side wins control of the yuan's direction will have a profound impact on global financial markets as well as the well-being of countries that have benefited enormously from the frenetic growth in the Chinese economy.

The yuan has been hammered in recent months by a confluence of factors. China's once booming economy is now growing at its most feeble pace in a quarter of a century and capital outflows have accelerated. The PBOC is lowering borrowing costs just as the U.S. Federal Reserve has begun lifting interest rates.

And because the yuan, or renminbi as it's also known, is tethered to the greenback, it has gained against peers such as the Japanese yen, despite falling against the dollar itself.

Confidence in the ability of policymakers to handle the crisis has also wavered amid several policy missteps, helping create a toxic mix has emboldened investors to bet that the yuan is heading for a precipitous fall.

"There has been a growing market belief that the yuan will weaken and in this respect there has been an increase in short yuan trades since the summer through the offshore market, options and non-deliverable forwards," Mitul Kotecha, head of Asian rates and currency research at Barclays, said.

"China has plenty of reserves but the significant fall in recent months at a time China was gradually guiding the yuan lower suggests the capital account is pretty leaky."

The PBOC has introduced a slew of measures to arrest the slide. It has asked banks making yuan loans abroad to set aside more in reserves and has also hoovered up yuan in Hong Kong, a key market where the bearish bets have been made, effectively making it more expensive for traders to borrow the yuan to make these trades.

China's state-owned publications have also chipped in with stinging editorials admonishing greedy speculators for betting against the currency. Prominent investor George Soros was recently likened to a "crocodile" that had declared "war" on China for suggesting the country's economy was heading for a hard landing.

The hefty interventions by the PBOC caught some hedge funds off guard.

Bill Ackman's Pershing Square said in a January 26 investor letter that the fund's had bought currency put options (contracts that give the investor the right, but not the obligation, to sell an asset a predetermined price in the future) in the hope of offsetting potential losses on its broader Chinese investments.

The options had not been as lucrative as hoped due to China's move to prop up the yuan, while the broader Chinese investments had lost more value than expected.

In the letter, high-profile activist investor Ackman called the Chinese central bank's peg protection "inadvisable," but said the fund would hold onto its trades.

China's efforts to defend currency have come at a cost though. China's foreign exchange reserves, the world's largest, fell by more than $500 billion last year to stand at $3.33 trillion at the end of 2015 as the central bank intervened aggressively.

"The $3 trillion mark is an important psychological level and if reserves fall below this mark, that would encourage the yuan bears," said Khoon Goh, currency strategist at ANZ.

Goh said further measures may be introduced to support the currency, including tighter rules on documentation, as well as new regulations that make it harder for companies to make foreign investments.

Additional capital restrictions could also be put in place, although that would represent a somewhat embarrassing reversal given the International Monetary Fund only added the yuan to its exclusive group of reserve currencies late last year because the yuan fit the requirement that it be "freely traded."

Strategists widely expect the yuan to weaken, though the pace at which the currency will fall is less clear. Kotecha at Barclays forecasts the dollar/yuan rate at 6.8 by mid-year and 6.9 by the end of 2016, while Goh said it was difficult to call a likely winner.

"What it all boils down to is who has more firepower and who is willing to hold out," Goh said.